Capital Gains: Don’t Pay it Forward, and More.

Congress rights an accounting wrong; Plus...

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WHAT ARE THE ODDS?

Looking out for number one, or any other single digit, is one way to fight accounting fraud. Statistical sleuths are using a software package based on Benford’s Law–which predicts how many times a given digit appears at the beginning or end of numbers within a data set– to ferret out accounting inconsistencies. Developed by Dallas-based accountant Mark Nigrini, the software is running at 3 percent of the world’s multinational companies, combing data for deviations in the expected patterns.

American Airlines Inc. has used the software since 1995 to sniff out suspicious data faster, says Jonathan Bryant, IT audit department manager at the Fort Worth­based airline. “We’re able to be more proactive in finding fraud, rather than waiting for a phone call from our tip hotline,” he says.

The analysis works best on large data sets, such as those maintained by airlines, banks, and retailers, says Nigrini, who counts KeyBank Corp., Office Depot Inc., and Best Buy Co. among his customers. The software cannot distinguish between fraud and error, but auditors link most pattern deviations to errors. – Alix Nyberg

CAPITAL GAINS
Don’t Pay It Forward

In stickball, it’s called a “do over.” In Congress, it’s a correction. Whatever the label, the House and Senate went to bat for small business by amending an existing tax law that thwarted pint-size mergers and acquisitions all last year.

In one of its last acts before adjourning in December, Congress publicly admitted it had made a mistake, and passed the Installment Credit Tax Correction Act of 2000, which amended a federal tax repeal buried in the Ticket to Work and Work Incentives Improvement Act of 1999. The 11th-hour correction allows small businesses that employ the accrual-accounting method to use installment sales rules as well, something they had been banned from doing since the earlier repeal the previous December.

At first, no one realized that the 1999 change would have such a chilling effect on small-business transactions, notes Christopher Myers of the U.S. Chamber of Commerce. The statute hurt owners who used accrual accounting when they sold their businesses at a profit, primarily because it forced them to pay all the capital-gains tax in a lump sum, even if the payouts were scheduled to take place over several years.

As a result of the 1999 repeal, says Myers, owner-provided financing dried up, because owners could not afford to take the tax hit up front. “In some cases,” says Dorothy Coleman of the Washington, D.C.-based National Association of Manufacturers, “sellers had to borrow money just to pay the tax bill.” And, adds Myers, “Some individuals even went bankrupt from having to pay their bill.”

Small-business owner Jim Wordsworth of McLean, Va., witnessed the practical effect of both laws. He sold one of his two steakhouses for $200,000 in mid-1999. Like many small-business owners, he spread out the payments over the next five years to avoid, among other things, a lump-sum tax burden. However, the 1999 repeal made it virtually impossible for the Beltway restaurateur to consider cashing out his second business. “If the first deal had been completed one year later, I would have had to pay a capital-gains tax of 25 percent in 2000,” says Wordsworth. – Steve Bergsman

MINOR-LEAGUE WAGES

Federal Reserve Board chairman Alan Greenspan got an 11% raise, bringing his 2001 government salary to $157,000. That’s about what pro baseball’s Alex Rodriguez makes in one game. And the Texas Ranger shortstop gets the winter off.

NEW PURVIEW: The House Financial Services Committee takes on new duties this year–all securities and insurance matters.

SOFTWARE DEVELOPMENT
Tax Code Flashback

Stung by recent failures in the courts, in December the Internal Revenue Service rewrote a crucial 30-year-old rule governing the tax treatment of software development. The result is Revenue Procedure 2000-50.

Back in 1969, the IRS stated in Revenue Procedure 69-21 that it would not challenge firms that treated software development as a research and experimentation (R&E) cost as defined by Section 174 of the tax code. Under the code, companies have the option of either deducting or capitalizing R&E (more commonly called research and development) costs.

Although the IRS never officially said that software development was R&E, its waffling over how to classify the process enshrined that presumption during the next three decades, says David Hardesty, vice president of San Francisco­based accounting firm Markle Stuckey Hardesty and Bott. The idea that software development was considered R&E bolstered company claims for research credits, and allowed start-up companies–which are typically required to capitalize expenses–to deduct R&E costs.

With 2000-50, software development is not presumed to be an R&E cost under Section 174, says Hardesty. “You have to prove it is,” he notes, adding that the rule may indicate that the IRS will fight harder on this issue. One of the agency’s recent court defeats was at the hands of Tax and Accounting Software Corp., a Tulsa, Okla.-based maker of tax software. TAASC sued the IRS after an audit denied its research credits for 1993 and 1994, and jeopardized its 6.5 percent R&E credit for all subsequent years, says CFO Kenneth P. Young. “We had $2 million to $3 million a year in research-related expenditures that [could] potentially be called into question,” he says. – Tim Reason

THE SIMPLE LIFE

Want one number to link your phones, faxes, and E-mails? Telcordia Technologies and VeriSign’s Enum project aims to establish a single telephone number for all registered users.

LOSING BIG TO LAWSUITS

When Warren Buffet filed with the Securities and Exchange Commission in November to buy a 14.9 percent stake in Chicago-based USG Corp., he told CFO Richard Fleming that the construction- materials company was undervalued. That same month, Southeastern Asset Management and Germany’s Knauf bought large stakes in USG. After the purchases, however, both Moody’s Investors Service and Standard & Poor’s downgraded USG’s credit rating, bucking the company’s seven-year upward trend with ratings agencies.

The missing piece of the puzzle is asbestos litigation, a liability that USG, and dozens of other companies, have battled for decades. So far, claims from asbestos-related lawsuits have pushed 26 companies into bankruptcy.

The capital markets also punished companies that carried the asbestos stigma. Stock and bond prices of stalwart companies like USG, Georgia-Pacific Group, and W.R. Grace & Co. tumbled last year under the weight of lawsuit claims. Meanwhile, Moody’s reported downgrading the credit ratings of a record 17 corporations in the first nine months of last year, and another 11 in the fourth quarter. Many of the affected companies are in the asbestos industry, and all of them are suffering through massive lawsuits.

Corporate finance consultant Joseph Cantwell of Cantwell & Co., in Chatham, N.J., says the situation doesn’t spook investors. He has seen no signs of alarm from his corporate clients based on last year’s downgrades. But investors are jittery about high-profile lawsuits, says Barbara Allen, a New York­based senior analyst at Arnhold and S. Bleichroeder. She tells investors to pay close attention to earnings per share, whether earnings revenue is covering debt, and how companies are managing asbestos liability.

Allen says USG is on the right track with the way it manages asbestos liability. The company has taken a charge against earnings each quarter to handle the lawsuit claims, and it took another charge in January of $557
million to cover claims that might occur during the next few years.

– Leslie Schultz

LAW FIRMS are desperately seeking bankruptcy attorneys, says Schneider Legal Search, which has seen requests double since June.

COMMUTER TAX BENEFITS
Commuters, Abandon Your Cars!

The federal government wants companies to help curb commuter traffic, and they are dangling a
financial carrot to spark interest. In a move billed as an effort to reduce traffic congestion, air pollution, and employee stress, the feds are trying to lure commuters out of their cars via tax cuts.

Dubbed Commuter Choice, the awareness campaign is backed by the Environmental Protection Agency and the Department of Transportation, and aims to convince corporations to offer commuters tax breaks as part of standard employee benefits packages. Seven commuter-friendly companies have already signed on to set an example: Pitney-Bowes, The Calvert Group, Nike, Intel, Walt Disney, Kaiser Permanente, and Geico Direct.

In 1998, the Internal Revenue Service gave companies the green light to let employees pay for transit passes out of pretax income, and has since broadened the law to allow employees to bank pretax cash with employers for commuting expenses. This is much like the flexible- spending accounts that companies provide for pretax health-care expenses.

The idea is that employers save on payroll taxes, while employees save on income taxes. The government does not track how many employees participate in commuter programs, but Commuter Check Services Corp., which sells tax-deductible vouchers for mass-transit fares in 10 major cities, claims that its customer base doubled to 4,000 since the legislation was passed.

Reducing commuter traffic bodes well for the environment, but even proponents of the measure say the annual cap on pretax deductions–currently $780 per employee–means federal payroll tax savings are too low to be the main selling point to employers. “We don’t sell this as a huge savings for employers,” says Marsha Gordon, president of Stamford, Conn.-based commuter services organization Metropool Inc. “It’s really more of a recruiting and retention tool.”

Ed Houghton, director of employee relations at Stamford-based Pitney-Bowes Inc., agrees. Train ridership among employees increased 30 percent when the company began offering the option two years ago. Yet Houghton says the goal is not to save on payroll taxes. “If we can reduce traffic enough to reduce commute times, we can widen our recruiting circles,” he says.

While little comprehensive data exists on how commuting options affect recruiting and retention, companies report some improvement. At Bethesda, Md.-based The Calvert Group, for example, employee turnover dropped from 25 percent to 12 percent after the company offered to pay transportation costs in full. However, experts on commuting expect diminished results when employers aren’t as generous.

The Association for Commuter Transportation (ACT), in Washington, D.C., is campaigning to increase the monthly deductible cap for mass-transit and vanpool fares to $175. Absent further legislation, the cap will increase to $100 per month in 2002. ACT is also looking to add federal tax incentives for commuters who carpool or ride bicycles to work.– A.N.

WHO’S DOING IT
A sample of state commuter programs now in full swing.

STATE PROGRAM TAX-CREDIT RULES RESTRICTIONS
Maryland Commuter Tax Credit (www.mtamaryla nd.com) 50% of employers’ costs for transit passes and vanpool subsidies, up to $30 per employee per month None
Connecticut Traffic Reduction Programs Credit (www.drs.state .ct.us) 50% of employers’ costs for traffic-reduction programs and services, up to $250 per employee per year Must have at least 100 employees; reimbursement fund capped at $1.5 million
Oregon Business Energy Tax Credit (www.energy .state.or.us) 35% of employers’ costs for transit passes, carpooling, shuttles, and teleworking arrangements Must apply for credit before starting project
Minnesota Transit Pass Credit (www.taxes.s tate.mn.us) 30% of employers’ costs for transit passes and vanpool subsidies None

SOURCES: ENVIRONMENTAL DEFENSE FUND, STATE AGENCIES, ASSOCIATION FOR COMMUTER TRANSPORTATION

DOWNGRADES RISING: Moody’s Investors Service downgraded a record 470 U.S. companies in 2000, far exceeding its 217 upgrades.

INSURANCE
Gruesome Calculations

The scenarios come straight from a Wes Craven horror-film script: a company truck hits a school bus full of children, or a five-star hotel battles a deadly salmonella outbreak. Prodded by the resulting class-action suits that can subtract hundreds of millions of dollars from a company’s bottom line, CFOs now must engage in worst-case scenario planning, and purchase excess liability insurance coverage accordingly.

A survey published by New York­based insurance broker Marsh Inc. says that the average amount of liability insurance coverage companies bought last year increased to $105 million, up 5.6 percent from the previous year. The broker also blames escalating tort awards for the continuing rise in the amount of coverage purchased. The abundance of $50 million to $200 million legal claims can “attract the attention of anyone,” contends Timothy Brady, a Marsh managing director.

With regard to wrongful-death or severe- injury awards specifically, Brady says that $3 million to $5 million per person is not unusual in today’s legal environment, adding that some injuries, such as paralysis and serious burns, can cost corporate defendants up to $20 million.

This year, however, financial executives will have to balance the need for protection with rising premiums. For the first time since the late 1980s, insurance rates are climbing sharply, says insurance agent Marc Blumencranz, a partner at BWD Group LLC, in Jericho, N.Y.

Based on renewal notices from insurance companies, BWD estimates a 10 to 15 percent rise in rates this year, with premiums for the upper layers of coverage exceeding that. For example, a real estate and hotel management company that paid $150,000 for an umbrella package in 2000 can expect to pay $250,000 in 2001, according to Blumencranz. And premiums for excess liability coverage within that umbrella will double, from $500 to $1,000 per $1 million of protection.

– David M. Katz and Marie Leone

SPY GAMES

CEOs and a new counterspy czar will be meeting on a regular basis, if President Bush doesn’t nix the idea. In January, President Clinton created the post, which will have close ties to business.

ONLINE BANKING
Waiting Game

Commercial banks aren’t exactly rushing headlong into E-commerce. According to Larry Forman, director of Ernst & Young LLP’s annual cash- management survey, only about 60 percent of the top banks surveyed currently offer Internet-based information reporting to their corporate customers. Just 34 percent offer online transfers between accounts, and 31 percent offer automated clearinghouse services.

Progress in this area seems slow, and Forman offers two reasons: electronic banking is a high-risk activity that requires foolproof security, and corporate treasurers at large companies are content with dial-up services for now.

That’s true for Atlanta-based Southern Co. Spokesperson Marc Rice says the global company is waiting for banks to provide a full menu of cash management services to replace the piecemeal offerings available today. Southern’s treasury department also wants better assurances of online reliability and security before it begins E-based banking. – M.L.

IPO PROBE
The SEC Spins Its Wheels

Public embarrassment and negative publicity, not fines and prison terms, are the penalties being discussed in connection with the latest Wall Street crackdown on the allocation of shares from initial public offerings. As the Securities and Exchange Commission’s investigation into IPOs widens, deal- and market-makers liken it to the 1997 probe into “spinning” IPO shares.

The spinning scandal–an inquiry into the quick turnover of IPO shares–eventually turned into a paper tiger that left the SEC with allegations that were too difficult to prove, and a trail of editorial coverage that did little more than embarrass the participants. The allegations “died on the vine,” says Richard Y. Roberts, a partner with Thelen Reid & Priest LLP, in Washington, D.C., and a former SEC commissioner.

This time, the U.S. Attorney General’s office in Manhattan is involved in the probe, raising the specter of criminal wrongdoing. But Roberts and other legal eagles won’t venture a guess as to what criminal charges could be in the offing. Civil violations, much less associated penalties, probably will never materialize. The major reason: the SEC does not have IPO allocation standards, says Roberts. IPO allocation is, and always has been, at the discretion of the securities industry, and it would not be fair to enforce standards retroactively, he says.

The SEC has remedies if it does uncover violations, such as fraud. Among the civil penalties available are fines, injunctions against the wrongdoing, and suspension of brokers’ licenses. So far, the investigations don’t seem to warrant any of those responses.

– John P. Mello Jr.

THE BOTTOM LINE: IPO allocation standards don’t exist, so SEC probes often just fade away.

DESPITE THE ECONOMIC slowdown, a Manpower Inc. survey of 16,000 companies found that 27% plan to increase staff in 2001.

E-PHILANTHROPY
Internet Sours Sweet Charity

It is better to give than to receive, unless your company gets trapped in the murky waters of E-philanthropy. The practice of using the Internet to solicit or make charitable donations is innovative, but like any new idea, E-philanthropy has start-up glitches to work through, including tax questions tied to lobbying communications, surrogate Web sites, unrelated business income, and corporate sponsorship.

“The Internet changes things just enough so that when businesses apply traditional tax rules, the analogies break down,” warns Putnam Barber, editor of the nonprofit portal www.nonprofits.org. Witness the Internal Revenue Service’s most recent call for public comment on calculating Internet E-mail costs. By law, nonprofits must track how much they spend on lobbying communications to prevent charities from exceeding federal spending caps. In a traditional, direct-mail newsletter campaign, the calculation of expenses is straightforward. However, says Barber, the incremental cost of sending additional newsletters via E-mail is difficult to determine.

Another snag involves surrogate Web sites that aggregate and clear donations for nonprofits that don’t want to maintain complex financial functionality on the Web. The surrogates, which act as middlemen, are sometimes for-profit businesses, says Catherine Livingston, a former Treasury deputy tax legislative counsel who is now with Caplin & Drysdale, in Washington, D.C. “If the middleman site did not establish the proper relationship with the charity,” she says, “the tax treatment of a donation may be different than expected.” Requesting a receipt for a donation also causes problems. Acknowledgment from a surrogate Web site doesn’t satisfy IRS requirements, unless the surrogate is an agent for the charity.

Corporate sponsors must also tread lightly on the Web. Some charities set up sponsorship programs that link their nonprofit Web site to an E-commerce site, such as Amazon.com. The idea is to create an Internet link out of the corporate sponsor’s logo that connects the commercial and nonprofit sites. The E-commerce company then donates a percentage of the profits from purchases that originate at the logo, which sits on the nonprofit site. It sounds fruitful, but Livingston says the IRS is still unsure whether the stream of revenue created by the link is subject to unrelated business income taxes.

A more serious problem occurs when corporate Web sites also play host to corporate foundation activities. “There are a lot of rules that apply to private foundations under the tax laws, and it’s easy to run afoul of those,” counsels Livingston. For instance, corporations are allowed to lobby for legislation, but corporate foundations are banned from lobbying. The corporate Web site should not create the impression that the foundation is soliciting votes on Capitol Hill. – S.B.

TELL ALL

The IRS is making a list of the most contentious corporate tax issues, and it needs company input by Feb. 28. The agency wants to clear up murky tax law interpretations and cut costly delays.

BANK STOCKS
Lender, Heal Thyself

Bank stock prices are sputtering, and investors are pointing a finger at bad loans as a reason for selling. Credit-
rating agency Standard & Poor’s in New York identified 118 corporate defaults totaling $41.8 billion in debt in 2000. “Defaults continue to soar,” says Leo Brand, director of risk solutions at S&P.

But bad loans are getting a bad rap. “Corporate defaults shouldn’t affect the banks’ bottom line,” notes Diane Glossman, a bank analyst with UBS Warburg in New York. “What most investors fail to realize,” she explains, “is that thanks to intermediation, defaulted corporate debt is no longer primarily in the hands of banks: it largely resides with mutual funds, insurance companies, and other institutional investors.”

Glossman asserts that banks took a hit on Wall Street because companies felt the pain of their investment banking and trading business arms. “The lack of issuance, and relative slowdown in investment banking, have dried up earnings over the course of the year for banks that have a significant portion of earnings tied to capital-markets activities,” she notes.

Glossman says not to blame sinking stock prices on technology investment, either. She predicts that banks will continue to spend heavily on technology and invest in infrastructure and Web-based products in order to serve customers. She maintains that technology costs are “nothing new” and should not pose a threat to earnings.

– Jake Wengroff

UNPLUGGED: Users of wireless data devices will approach 10 million this year, according to Yankee Group estimates.

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